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Audit Risk. The possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated This is the risk that the auditors will issue an unqualified opinion on financial statements that contain a material departure from GAAP.

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audit risk
Audit Risk

The possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated

This is the risk that the auditors will issue an unqualified opinion on financial statements that contain a material departure from GAAP.

Auditors must obtain sufficient appropriate audit evidence to reduce audit risk to a low level in every audit.

financial statement assertions
Financial Statement Assertions

Assertions about account balances (Accounts)

Assertions about classes of transactions and events (Transactions)

Assertions about presentation and disclosure (Disclosures)

combined assertions used in this text
Combined Assertions Used in this Text

Existence or Occurrence--Assets, liabilities, and equity interests exist and recorded transactions have occurred

Rights and Obligations--The company holds rights to the assets, and liability are the obligations of the company

Completeness--All assets, liabilities, equity interests, and transactions that should have been recorded have been recorded

Cutoff—Transactions and events have been recorded in the correct accounting period

Valuation, Allocation and Accuracy—All transactions, assets, liabilities and equity interests are included in the financial statements at proper amounts

Presentation and Disclosure--Accounts are described and classified in accordance with generally accepted accounting principles, and financial statement disclosures are complete, appropriate, and clearly expressed

audit risk6
Audit Risk

Risk of Material Risk That the

Audit Risk = Misstatement * Auditors Fail to

the Misstatement

= Inherent Control Detection

Risk * Risk * Risk

Inherent Risk--Risk of a material misstatement occurring in an assertion assuming no related internal controls.

Control Risk--Risk that a material misstatement in an assertion will not be prevented or detected on a timely basis by the company’s internal control.

Detection Risk--Risk that the auditors’ procedures will lead them to conclude that a material misstatement does not exist in an assertion when in fact such misstatement does exist.

audit risk formula
Audit Risk Formula

AR = IR * CR * DR

AR = Audit risk

IR = Inherent risk

CR = Control risk

DR = Detection risk


Audit Risk

Figure 5. 2

inherent risk
Inherent Risk

Factors that affect inherent risk:

Nature of the client and its environment

Nature of the particular financial statement element

Business characteristics indicative of high inherent risk:

Inconsistent profitability of client

Operating results highly sensitive to economic factors

Going concern problems

Large known and likely misstatements detected in prior audits

Substantial turnover, questionable reputation, or inadequate accounting skills of management

assertions with high inherent risk
Assertions with high inherent risk


Difficult to audit transactions or balances

Complex calculations

Difficult accounting issues

Significant judgment by management

Valuations that vary significantly based on economic factors

types of transactions
Types of transactions


Recurring financial statement activities recorded in the accounting records in the normal course of business

Lower inherent risk


Involve activities that occur only periodically such as the taking of physical inventories

High inherent risk

Estimation transactions

Activities that create accounting estimates

Higher inherent risk

the third field work standard
The Third Field Work Standard

Third standard of field work:

The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to perform a reasonable basis for an opinion regarding the financial statements under audit

Sufficient audit evidence

The quantity of audit evidence that must be obtained

appropriateness of audit evidence
Appropriateness of Audit Evidence

To be appropriate audit evidence must be:



Principles—Audit evidence is ordinarily more reliable when it is

Obtained from knowledgeable independent sources outside the company rather than nonindependent sources

Generated internally through a system of effective controls rather than ineffective controls.

Obtained directly by the auditor rather than indirectly or by inference

Documentary in form rather than oral

Provided by original documents rather than copies

reliability of certain types of audit evidence
Reliability of Certain Types of Audit Evidence
    • High Physical Inventory Observation
  • Documentary
  • External Cutoff Bank Statement
  • External/Internal Purchase Invoice
  • Internal Sales Invoice
    • Low Client Representations Management Representation
    • Letter
overall types of audit procedures
Overall Types of Audit Procedures

Risk assessment procedures

To obtain an understanding of the client and its environment, including its internal control, to assess the risks of material misstatement

Further Audit Procedures

Tests of controls

When appropriate, to test the operating effectiveness of controls in preventing material misstatements

Substantive procedures

To detect material misstatements at relevant assertion level. Substantive procedures include (a) analytical procedures, (b) tests of details of account balances, transactions and disclosures

substantive procedures
Substantive Procedures

Analytical procedures

Tests of details

Tests of account balances

Tests of classes of transactions

Tests of disclosures

One may change the scope of audit procedures by changing the (NTE, or re-ordered as NET):

Nature (type and form)

Timing (when performed)

Extent (quantity of evidence obtained)

nature and timing of procedures
Nature and Timing of Procedures

Holding the extent of procedures constant, one may increase the scope of procedures (make them more effective) by either changing the

  • Nature-- obtain more reliable evidence
    • often externally generated evidence.
  • Timing--wait until year-end to obtain evidence from entire set of transactions as contrasted to performing interim testing, say two months prior to year-end and simply updating those procedures.
extent of procedures
Extent of Procedures

Holding other factors such as the nature and timing of procedures constant:

  • The greater the risk of material misstatement, the greater the needed extent of substantive procedures
  • The main way to increase the extent of audit procedures is to examine more items
  • Sample sizes should reduce detection risk so as to restrict audit risk to a low level
analytical procedures 1 of 2
Analytical Procedures (1 of 2)

Steps involved

Develop expectation of account (or ratio) balance

Determine amount of difference that can be accepted without investigation

Compare the company’s account (ratio) with the expectation

Investigate and evaluate significant differences

Developing an expectation

Prior period information

Anticipated results

Relationships among elements of financial information within a period

Industry information

Relationships between financial information and relevant nonfinancial data.

analytical procedures 2 of 2
Analytical Procedures (2 of 2)

Types of Expectations

Trend analysis—analyze changes in accounts of a company over time

Ratio analysis – compare relationships between two or more financial statement accounts or comparisons of account balances to nonfinancial data

Liquidity (e.g., current ratio)

Leverage (e.g., debt to equity)

Profitability (e.g., gross profit percentage)

Activity (e.g., inventory turnover)

ratio analysis
Ratio Analysis

Approaches to ratio analysis

Horizontal analysis

Review ratios over time

Cross sectional analysis

Analyze ratios of similar firms at a point in time

Vertical analysis

Analyze relationships within a period

“Common size” statements prepared

Other methods

Regression analysis, reasonableness test

basic approaches to auditing accounting estimates
Basic Approaches to Auditing Accounting Estimates

Review and test management’s process for developing the estimate.

Independently develop an estimate to compare to management’s estimate.

Review subsequent events or transactions bearing on the estimate.

auditing fair values
Auditing Fair Values

Inputs to use in applying valuation techniques (FAS 157)

Level 1 – inputs of observable quoted prices in active markets for identical assets or liabilities

Ex. A closing stock price in WSJ

Level 2 – inputs of observable quoted prices, generally for similar assets or liabilities in active markets

Ex. Company discounts future cash flows on its not publicly traded debt securities at rate used by market for publicly traded debt securities

Level 3 – inputs that are unobservable for the assets or liability

Ex. A private company uses judgment to determine a proper rate to discount the future cash flows of its not publicly traded securities

related party transactions
Related Party Transactions

Disclosure requirements must be met

Primary challenge is identifying undisclosed related party transactions

Determine related parties

Inquiries of management

Review SEC filings, stockholder’s listings and conflict-of-interest statements

Be alert for transactions with related parties and any transactions with unusual terms

functions of audit documentation
Functions of Audit Documentation

Primary functions:

Support the auditors’ compliance with auditing standards

Support the auditors’ opinion

Secondary functions:

Assist continuing and new audit team members in planning and performing the audit

Serves as a record of matters of continuing audit interest

Assists in supervision and review of the audit

Demonstrates the accountability of team members

Assists internal reviewers, external peer reviewers, PCAOB inspectors, and successor auditors in performing their roles

sufficiency of audit documentation
Sufficiency of Audit Documentation

Audit documentation should be sufficient to:

Enable an experienced auditor to understand the work performed and the significant conclusions reached

Identify who performed and reviewed the work

Show that the accounting agree or reconcile to the financial statements

Audit documentation should include all significant audit findings and the actions taken to address them

types of working papers
Types of Working Papers

Audit administrative working papers

Working trial balance

Lead schedules

Adjusting journal entries and reclassification entries

Supporting schedules

Analysis of a ledger account


Computational working papers

Corroborating documents

types of working files
Types of Working Files

Current files

Current year working papers

Index and cross-referencing

Permanent files

Items of continuing audit interest